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Barings Failure

BA849 Seminar in Finance National Institute of Development Administration Semester 3 / 2011 Ms. Supattra Maklum Ms. Linda Thipvoratrum Ms. Nodtaporn Chaichoochai Mr. Nopadol Kitsrinopadol ID# 5310212001 ID# 5310212004 ID# 5320212001 ID# 5320212003

Barings Bank was Britain's oldest merchant bank established in 1762. Collapsed in February 26, 1995 due to secretly derivatives trading on both the Nikkei225 and on JGBs (Japanese Government Bonds) by Nick Leeson. The damage: $1.4 Billion lost, reducing Barings Bank value from $500 million to $1.60.

Who is Nick Leeson?

Nicolas Leeson was born February 25, 1967. A former derivatives broker whose fraudulent actions brought down Barings Bank. During the 1980s, Leeson got a job as a clerk with a private bank, Coutts. Then, he worked at many other banks before settling at Barings Bank in 1989. He had been the star trader of the bank. Within a year, he had made alone 10 million pounds, which accounts for 10% of the bank profit for that year. BUT!!!!

Brief Storyline
Leeson joined Barings Bank as a back office employee with 100 million pound share in certification. Successful in back office position and then was promoted to a trader. Leeson was transferred to Barings Singapore branch as derivatives trader between Singapore Monetary Exchange (SIMEX) & Osaka Securities Exchange (OSE). Leeson set up Error Account 88888 to cover up a mistake made by an inexperienced team member, which led to a loss of 20,000 pounds. Leeson then used that account to cover his own mounting losses.

Brief Storyline
By December 1994, the red ink hidden in account 88888 totaled $512 million. Getting increase Leeson bet that the Nikkei index would not drop below 19.000 points. Leeson lost $1.4 billion due to his unauthorized speculative trading. Barings Bank was bankrupted. Leeson was arrested in Frankfurt, Germany. In December 1995, a court in Singapore sentenced him to six and a half years in prison. In 1999, Leeson was released.

Barings Official Strategy

Long on the Nikkei 225 futures listed on Osaka Securities Exchange (OSE) and short twice the number of contracts on Singapore Monetary Exchange (SIMEX). Official strategy: Take advantage of temporary price differences between SIMEX and OSE. (Switching strategy)

It required Leeson to buy the cheaper contract and simultaneously sell the more expensive one.

What Leeson Did.

But, Leeson did not short on SIMEX but longed the number of contracts he was supposed to shorted. These unauthorized trades was hidden under the account named Error Account 88888. Leeson sold straddles He earned premium income from over 37,000 straddles over a 14-month period. As losses mounted, he took on larger positions Rogue Trader He tried to sustain market by:
Buying tremendous amounts of Nikkei stock index futures. Selling Japanese government bond futures and betting that interest rates would rise.

What Leeson Did.

Leeson placed bets on the direction of price movements on the Tokyo Stock Exchange. He counted on the Nikkei index to rise.

If it did rebound, he would make profit on both the increasing stock value and increasing in interest rates.
However, his luck ran out when the Kobe Earthquake sent the Asian financial markets into a tailspin.


Source: International Financial Risk Institute

Leesons Positions
Nikkei 225 dropped further and the Nikkei 225 was around 17,950 At the end of February 1995, Leeson had leveraged his position to $7 Bn, holding about 61,000 contracts (55,000 March and 6,000 June)

Bought a substantial number of contracts, 11,000 after the earthquake. Believing that fall of the Nikkei 225 from 20,000 to 18,950 was only temporary.
Source: International Financial Risk Institute

How Did He Deceive?

Hid the losses in secret account: Account 88888 while using account 98007 (Barings London JGB Arbitrage) and 98008 (Barings London Euro Yen Arbitrage) to report to headquarters.

He was in charge of both back and front office.

He had checks and trading reconciliations signing authority. He was the only one who checks and see if records matched the actual sales.

No proper internal and risk management.

Concealed the loss

Source: International Financial Risk Institute

Tracks of the funding

Source: International Financial Risk Institute

Profitability of Leesons Trading Activities

Source: International Financial Risk Institute

Concealed Trading Losses

Source: Bank of England, Board of Banking Supervision

Where Did It Go Wrong?

Leeson mostly gambled on the direction of markets. A major part of his strategy involved the purchase of Nikkei-225 futures contracts. His only hedge was only the short position on Japanese Government Bonds (JGB).

He only made a one-sided bet.

Why Baring Collapse

Unauthorized speculative trading. Position of trader should be an arbitrage instead of hedging or speculating . Incompetent management
Failure of internal controls: Managers responsible for monitoring Leesons performance did not do their jobs. Fail of operational control system: No segregation of duties for the front and back office. No clear layout of reporting lines. Poor supervision of employees. Incompetency of external auditors (lack of knowledge about derivatives).

Lessons Learned
Something that is too good to be true Investigate! Do not trade by gambling.

Foundations for effective internal controls is a must.

Failure to implement an effective risk management system can lead to organizations catastrophe. Fall of Barings Bank was a wake-up call for financial institutions all over the world.

Thank you